The Economist Digest

“Falling Short”:

When Gertrude Janeway died in 2003, she was still getting a monthly cheque for $70 from the Veterans Administration — for a military pension earned by her late husband, John, on the Union side of the American civil war that ended in 1865. The pair had married in 1927, when he was 81 and she was 18. The amount may have been modest but the entitlement spanned three centuries, illustrating just how long pension commitments can last.

A pension promise can be easy to make but expensive to keep. The employers who promised higher pensions in the past knew they would not be in their posts when the bill became due. That made it tempting for them to offer higher pensions rather than better pay. Over the past 15 years the economics of the deal have become clear, initially in the private sector, where pensions (and health-care costs after retirement) were central to the bankruptcy of General Motors and many other firms.

“State of War”:

To be fair, fat-cat pensions in the public sector are far from typical. According to Alicia Munnell of the Centre for Retirement Research in Boston, the mean public-sector pension is just $20,000 a year, well below the average wage. But public-sector workers still seem to be getting a better deal than their private-sector equivalents, who usually have to work for 40 years to get full benefits. In the public sector the qualifying period is often shorter; in California, for example, highway patrol officers retire at 50, after an average of 28 years of service.

“A Nudge and a Wink”:

Albert Einstein is said to have described compound interest as the eighth wonder of the world. It should also be a boon for workers planning their retirement. Start saving early enough and a pension becomes much more affordable.

Unfortunately young people are often unable or unwilling to take advantage of this miracle. Their wages are low and their main priority may be to pay off their student debts or to save for a deposit on a house. Moreover, they may find it difficult to defer gratification or, as economists like to put it, they use hyperbolic discounting. Most of them would much rather have money in their hands today than put it aside for a retirement which they can barely imagine.

“Hiring Grandpa”:

When Winston Churchill reached the age of 65, his career was still regarded as a bit of a failure. Had he retired then, as most modern 65-year-olds would, he would never have become prime minister, made the speeches for which he has become famous or topped polls of the greatest Britons ever. Is the rich world ignoring the potential of its older workers whose finest hours could still be ahead of them?

“Pick a Number, Any Number”:

In the late 20th century the actuaries who advised pension funds thought a high rate was appropriate. Pensions are a long-term liability, so the employer can take a long-term view, buying equities and riding out the vicissitudes of the market. This will earn a higher return (the so-called equity-risk premium) than can be got from government bonds or cash. The contribution rate can be set to reflect this higher expected return.

For a while this view seemed to be borne out by the long bull market in equities. Many pension schemes were in surplus, allowing employers to take contribution holidays and to improve benefits. Few were inclined to question the numbers. “In the old days the actuaries were like Catholic priests handing down the word of God, in Latin, to the masses,” says John Ralfe, a pensions consultant.

“Too Much, Too Young”:

In the OECD public spending on pensions benefits has been growing faster than national output, rising from 6.1% of OECD in 1990 to 7% in 2007. It is forecast to reach 11.4% of OECD by 2050. Those forecasts already take into account the planned rise in retirement ages and a likely drop in replacement ratios and thus assume that voters will approve of pension reform even as the baby-boomers become a potentially powerful voting block of retired people.

“Sharing the Burden”:

The best way of reducing the overall pensions burden, almost everyone now agrees, is for people to work longer. They will get paid for the extra years, national output will be boosted and the cost of pensions will fall. Reforms are already pushing workers in that direction. Thanks to the steady demise of defined-benefit schemes in the private sector, employees will be more prepared to do so because they need to build up higher pensions in defined-contribution schemes. And as the supply of younger workers dries up, employers will become more willing to use older ones. With rising life expectancy, the pension age across the board is probably heading for 70.

“A Storm in the Windy City”:

For the unions, the answer is simple. Workers have been contractually promised pension benefits and have made their required contributions each year. It is no fault of the workers that the state has not funded the pensions properly, or that a banking crisis has caused the stockmarkets to underperform. Hank Scheff of the American Federation of State, County and Municipal Employees (AFSCME) thinks the answer lies in the tax system: “Illinois has an antiquated financial structure with a flat income tax and a narrow sales-tax base.” AFSCME points out that, for all the adverse publicity about lavish provision, the average public-sector pensioner in Illinois receives only $22,000 a year. Almost nobody works for the 45 years needed to retire on a full pension, worth 75% of salary.

“Over to You”:

With a DC pension, nearly all the risk is passed to the employees. James Poterba at the Massachusetts Institute of Technology, points out that a DC plan forces them to make a set of decisions, such as their contribution rate and their asset allocation, for which they may not be equipped. “A very large proportion of the population has no interest, knowledge or time to direct their 401(k) plans. They are known as the unengaged majority,” says Kristi Mitchem of State Street Global Advisors, a custody and fund-management firm.

The danger is that employees will underestimate the size of the pension pot they need and overestimate the investment returns they will achieve. The cost of providing pensions has risen over the past decade; investment returns have been poor and interest rates have fallen.

Sources and Acknowledgements

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